Reasons not to Use S Corporations

I am frequently asked to explain my conclusion that the LLC is the entity of choice, and is preferable to the S corporation.  In my opinion, the LLC is always (or nearly always) a better choice than the S corporation.  In my opinion, no well advised taxpayer will ever use an S corporation to transact business when the LLC is available as an option.

At a minimum, no taxpayer should ever transfer to any corporation any assets that can be expected either (i) to appreciate in value (e.g. real estate, aircraft, intellectual property); or (ii) to be depreciated for federal income tax purposes (e.g. tangible personal property such as machinery and equipment).  I will concede that there are some situations in which the S corporation is an acceptable choice, usually because there is only one stockholder, and because the corporation willnever own any material amount of assets that will appreciate in value or be depreciated or amortized for tax purposes, and because the corporation will not conduct any business that will ever be sold.  However, even in those cases the LLC is usually a better choice.  Below, I give some of the reasons for my recommendation.

Partial List of Reasons NOT to Use S Corporations

Permissible Stockholders:  S corporations can have as stockholders only individuals and some trusts.  Corporations (with one limited exception, involving Qualified S Corporation Subsidiary Corporations, or Q-Subs), LLCs and partnerships cannot be stockholders of S corporations.  In my experience, this limits the options and alternatives available to the owners of the S corporation in estate planning and asset protection planning and other tax savings techniques.

Special Allocations:  Special allocations are not permitted in the case of an S corporation.  On the other hand, special allocations are permitted in the case of LLCs and other entities that are taxed as partnerships.  In an LLC, ordinary income and loss, and capital gain and loss, can be allocated (subject to certain requirements) to those members who will benefit from them.  In the case of an S corporation, all items of income and deduction must always be allocated on a pro rata basis.

Step-up in Basis of Assets:  It has often been said that death can be a tremendous tax planning opportunity.  The Section 754 election permits the LLC to adjust (i.e. increase) its basis in its assets (so-called “inside basis”) upon the sale of a membership interest, or upon the death of a member of the LLC.  If an LLC interest is sold, or if a member dies, the LLC may increase its adjusted tax basis in its assets to correspond to the step-up in basis that is obtained by the purchaser or heir.  This election and tax savings opportunity is not available to S corporations; S corporations may not make Section 754 elections.
Employment Taxes; Medicare Taxes:  The argument is sometimes made that S corporations can be used to save employment taxes, usually medicare taxes.  In my opinion, this argument is more illusory than real.

Most taxpayers are aware that earned income is subject to employment taxes.  The social security tax (12.4 percent) is imposed (in 2001) on the first $80,400 of earnings each year.  Earned income in excess of this amount is subject to medicare taxes (2.9 percent).  As the argument goes, the S corporation can establish a salary or bonus for its stockholder-employees, and pay social security and medicare taxes only on the salary or bonus.  According to the argument, any amounts paid in excess of the salary and bonus would be treated as dividends, which are not subject to social security and medicare taxes.  This argument is severely undercut by the United States Tax Court’s October 15, 2001 decision in Veterinary Consultants, P.C. v. Commissioner.  There, the Tax Court ruled that payments made by an S corporation to its sole officer were subject to self-employment taxes.  The Tax Court declined to accept the corporation’s characterization of those payments as distributions of net income, rather than wages.  To the same effect is the Tax Court’s September 16, 2002 decision in Grey Public Accountant, P.C. v. Commissioner.

In my opinion, the argument begs the question.  The IRS is always free to argue that the amount of the established salary or bonus is too low, and that some or all of the “dividends” are in reality additional salary and bonus.  The issue is the same in the case of the LLC.  The LLC manager-employee can establish a salary, and can treat amounts in excess of the salary as profits distributions.  In either case, the question that must be addressed is the division of the distributions between earned income and unearned income.

Follow the Example of the National Accounting Firms:  All of the “Big 5” accounting firms and many of the national accounting firms are LLPs, which are taxed the same way as LLCs.  This fact is ignored by accountants who advocate S corporations for their clients.  Most state laws permit accounting firms (and law firms, engineering firms, medical practices and other professional services) to be S corporations and LLPs; not all state laws permit these firms to be organized as LLCs.  No Big 5 accounting firm is organized as a corporation—S corporation or otherwise.

Loans To and From Business Entities:  Loans to S corporations can be troublesome, and may result in involuntary revocation of the S corporation’s status.  State corporation laws usually require that loans between a corporation and an interested party such as a stockholder and/or director be approved by resolution of the board of directors and/or stockholders.  This requires that the board of directors and/or stockholders adopt resolutions and place them in the official records.  In my experience IRS auditors usually ask to inspect the corporate minute books when auditing a corporation.  If there are loans, IRS auditors will attempt to characterize loan repayments as taxable distributions, if the auditor discovers that the required resolutions are not present, or if there is no written promissory note.  Such a position, if taken by an IRS auditor, can be particularly serious in the case of an S corporation, since the tax rules require that distributions be made pro rata, simultaneously to all stockholders.  If one stockholder received a distribution that was not accompanied by pro rata distributions to the other stockholders, the IRS can treat the corporation’s S election as involuntarily revoked.  This will nearly always result in adverse tax consequences.  Even if the auditor does not actually enforce this position, in my experience the auditor will point this out, and use this position to extract some other concession from the S corporation.

Flexibility in Contributions and Distributions:  The rules that govern loans to and from LLCs are not as strict.  While it is desirable to document all such transactions, there is usually no express legal requirement to do so.  Thus, the IRS agent does not have the opportunity to argue that there was no valid loan, if the required paperwork or loan documents are not present.

In contrast to the foregoing discussion, regarding difficulties presented by stockholder loans to S corporations, LLC members enjoy considerable flexibility in making contributions to the LLC, and in withdrawing distributions from the LLC.  In my experience, LLC members often avoid utilizing loans.  Unlike an S corporation, there is no requirement that LLCs make distributions simultaneously to all members on a pro rata basis.  Often distributions are made to members at different points in time during the year.  An LLC will usually establish a capital account for each member.  The member’s capital account is increased by any capital the member contributes to the LLC, and is reduced by any distributions the LLC may make to the member.  Cash contributions to the LLC, and cash distributions by the LLC, do not usually constitute taxable events (as long as the LLC member has sufficient tax basis in the member’s percentage interest in the LLC).  Thus, rather than make a loan to a member, the LLC will instead make a capital distribution to the member.  The member’s capital account is reduced by the distribution.  Over time, the distributions to the members are usually (but not necessarily always) proportional to their percentage ownership interests.  From time to time, LLCs may make compensating distributions, to bring the members’ capital account balances into line with their respective percentage ownership interests.

IRS Rules Regarding Interest on Loans:  Loans to and from an S corporation can be difficult for other reasons, as well.  The IRS requires that loans in excess of $10,000, and that are outstanding for more than 6 months, bear interest at or in excess of the “applicable federal rate” for the term of the loan.  If interest is not charged, the IRS requires that interest be “imputed.”  Frequently, this results in a mismatching of interest and other income; in other words, the interest might be “trade or business” interest to the S corporation, and “portfolio” income to the S corporation stockholder.  As noted above, LLCs are often able to avoid the accounting complexities that can be associated with loans.

Gain Recognition on Distribution of Assets:  Corporations, including S corporations, recognize gain when they distribute assets to their stockholders.  With only a few exceptions, LLCs do not recognize gain upon the distribution of assets to their members.

Corporate Formalities:  State business corporation laws require certain formalities in connection with corporations.  Ordinarily, corporations are required to have at least one annual meeting of stockholders and one meeting of the board of directors each year.  A corporation’s good standing can be subject to question if the required meetings are not held and documented. While it is advisable for LLCs to have meetings of their members and managers, and to document key business decisions, the required formalities are considerably less.

Periodic Elections of Directors and Officers not Required:  State business corporation laws usually require periodic elections of directors and officers.  While LLCs can choose in their organizational documents to have annual elections of managers, this is not required.

Eligibility for S Corporation Treatment:  Only certain corporations are eligible to be S corporations.  There is always the possibility that a corporation will elect to be taxed as an S corporation, and then lose its eligibility for this status.  Loss of eligibility nearly always results in adverse tax consequences to the former S corporation and its stockholders.  Loss of eligibility can occur, for example, if an ineligible person becomes a stockholder, or in some cases if the S corporation receives too much passive income.  On the other hand, there is no such risk in the case of an LLC.  An entity that is formed as an LLC does not risk losing eligibility for this status.

Sale of Business:  Like marriages, corporations are relatively inexpensive to create, but can be costly to dissolve.  If a business will ever be sold, the LLC is always preferable.  Many purchasers of businesses will refuse to purchase the stock of a corporation or the membership interests in an LLC, and will instead insist on purchasing the assets of the business.  Various reasons exist for this.  One principal reason is that the purchaser of corporate stock or LLC membership interests is not able to deduct, amortize or depreciate for tax purposes any portion of the purchase price.  Nor is the purchaser able to amortize or depreciate the corporate stock or LLC membership interest that is purchased.  There can also be accounting-related disadvantages for a purchaser of corporate stock or LLC membership interests.

On the other hand, a purchaser of the assets of a corporation or LLC can usually deduct some part of the purchase price, and depreciate or amortize all or nearly all of the rest of the purchase price.  Thus, the purchase can be made with before-tax dollars.  With state and federal tax rates exceeding 50 percent in some places, there can be a substantial economic distinction between before-tax and after-tax dollars.

The seller of the business that has been incorporated will usually prefer a sale of the stock or membership interests.  In most cases the seller of corporate stock pays tax on the transaction only once, at capital gain rates.  On the other hand, a double tax often results when a corporation (C corporation or S corporation) sells its assets.  An asset sale actually consists of two transactions.  First, the corporation sells its assets and pays tax, at ordinary income rates and/or at capital gain rates, depending upon the nature of each asset sold.  Second, the corporation distributes the sale proceeds to its stockholders.  A second tax is imposed on this second transaction.  The results can be even more disadvantageous if the transaction includes an installment sale.

Tax Basis Issues:  In contrast to the corporate stockholder, the LLC member usually finds a more acceptable tax result when the LLC sells its assets.  With only minor exceptions, the tax liability is usually less when an LLC sells its assets.  In fact, with only a few exceptions that are not frequently encountered, the LLC can usually liquidate without tax consequences.  Unlike the S corporation stockholder, the LLC member does not ordinarily face a second level of taxation when the LLC sells its business assets.  LLC members receive an increase in federal income tax basis for their membership interests (so-called “outside basis”) that correspond to their shares of LLC indebtedness.  An increase in federal income tax basis provides a number of potential advantages to the LLC member.  One such advantage is that an increased federal tax basis enables the LLC member to make greater use of any tax losses that may be generated by the LLC.  S corporation stockholders do not receive an increase in basis for the S corporation’s debt.  This can be a limitation on the ability of the S corporation stockholder to utilize tax losses.

Transfer for Value Exception for Life Insurance:  Many businesses purchase life insurance for any number of purposes, such as to provide funding for buy-sell agreements, and so-called “key man” insurance.  Most taxpayers are aware that life insurance proceeds are income tax-free to the beneficiary.  An exception exists when there has been a transfer for value of the life insurance policy.  If the need for S corporation-owned life insurance ends, a distribution of the life insurance policy often constitutes a “transfer for value,” ending the tax-free nature of the life insurance proceeds.  This trap does not ordinarily exist in the case of the LLC.  An LLC can usually distribute a life insurance policy to the insured member without loss of this important income tax benefit.

Summary and Conclusion

Certainly, individual circumstances, goals and expectations must be carefully considered in selecting an entity to use for business and investment activities.  In the vast majority of cases, the S corporation is over-utilized, and the LLC is the preferable alternative.  As pointed out above, there are some circumstances in which the S corporation is an acceptable choice.  However, as suggested above, those are limited to situations in which there is only one stockholder, the corporation will never own any material amount of assets that will be appreciated in value or be depreciated or amortized for tax purposes, and because the corporation will not conduct any business that will ever be sold.  However, in my opinion, the LLC is usually a better choice in these situations, as well.

I do not wish to be understood as never recommending any form of corporation as a business entity.  Many situations exist in which the C corporation merits serious consideration.  This letter is limited in scope to the S corporation.  As stated above, and in my opinion, the LLC is the preferred alternative to the S corporation.